THE ECONOMY

It's the Interconnectedness, Stupid

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While Congress has been working to legislate financial reform, the International Monetary Fund has been studying it.

The result of the IMF's analysis, contained in last month's Global Financial Stability report, echoes some of the items in the pending U.S. financial reform bills, but differentiates itself by addressing concerns such as global systemic fault lines while not dwelling on the misconduct of individual banks and institutions. In essence, the IMF puts forth financial reform needs that lawmakers here have failed to fully grasp.

The strengths of the IMF analysis are threefold. It places the financial crisis and the reform in the context of underlying monetary and fiscal policy factors; it acknowledges the importance of linkages among institutions in derivatives, liquidity provision, and the international nature of systemically important financial institutions; and finally it backs its analysis with voluminous data and economic analysis. Congress has largely skipped the study-and-reflect stage and proceeded directly to legislation. The process itself has largely been political and has proceeded without any regard to the international aspects of the issues involved.

Both the IMF study and bills in Congress propose moving derivatives onto central counterparty and exchange-traded platforms. The case for doing this is a strong one. The problems lie in the details, both technical and political. The IMF study emphasizes that, above all, a central counterparty has to be sound. This means that margining, contract listings, and how central counterparties are regulated need to be designed with that consideration foremost. The political give-and-take in which important details are being decided in Congress is ill-designed to ensure safety. The dealer firms and major users who will be disadvantaged, vis-à-vis the status quo, argue their interests strenuously. The potential reduction in systemic risks has few advocates and the benefits are less concrete than the costs.

Both the legislation and the IMF study propose to treat systemically important nonbank financial firms differently than other financial institutions. Congress would place these firms under a new prudential regulator, though the specifics are vague. This idea is picked up in the IMF proposals. However, measures to clean up the whole archaic and Byzantine U.S. legal and financial regulatory system are largely absent in the legislation. The bills also propose creating a separate insolvency regime and funding liquidations with assessments on large financial institutions. The IMF proposal is to impose capital surcharges on systemically important financial institutions and thus focuses on prevention of failure rather than making failure resolution more palatable to regulators and legislators. The IMF preventative approach avoids creating further legal complexity and uncertainty, and changing the enforceability of existing contracts in insolvency. However, economically feasible capital charges will not be sufficient in severe crises. Nor are big financial institutions solely responsible for the crisis. The proposals to make individual firms safer or less systemically consequential ignore the far more challenging problem of understanding and then supervising the exposures among institutions.

The IMF study ignores consumer protection. The financial crisis played into long-standing tensions between state and federal financial regulation of financial products. It is true that the crisis had its roots in part in lending to unsophisticated people who were subsequently unable to makes their payments. But it also had its roots in the willingness of supposedly sophisticated investors and banks to buy the securities concocted out of those loans. This is largely a U.S. political issue.

By its nature the IMF takes an international and macroeconomic perspective on financial crises and their causes. The U.S. reform effort has quickly focused attention on major financial institutions, their malfeasance, and the need to control them. This is unfortunate. The fuel for the crisis came out of public housing policy, the expansion of credit enabled by an expansive monetary policy, and long-sustained trade imbalances. The unwillingness of the administration and Congress to examine these broader causes and the shifting of attention away from public-policy failures means that lessons will be unlearned and another crisis more likely. The U.S. is far from being Greece, but it is foolish to suppose that it is immune to the sorts of structural problems and policy mistakes that lead to financial crises.

Bliss is the F.M. Kirby chair in business excellence at the schools of business at Wake Forest University.

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